What is outsourcing?
A lot of jargon has developed around outsourcing. At its simplest outsourcing from a lawyer's perspective is no more than a services agreement, an arrangement whereby a service provider is contracted to provide specified services for a client business. However, there are certain aspects of what are considered to be outsourcing arrangements which differ from normal service agreements. The first is the scope of the arrangement - an outsourcing agreement can often involve the provision of services which are business critical to an operation. The second is the length - they can be entered into for long periods. Third, true outsourcing involves an initial transfer of assets and employees from the client business to the service provider.
Various terms are used to describe sub-categories of outsourcing agreements or service agreements similar to outsourcing agreements such as application service provider agreements. For the purposes of this presentation it is advantageous to elaborate on two areas of outsourcing. One is IT or IS outsourcing. This is the provision of IT or IS services - applications that support business processes - typically including one or more of the following: data centre; voice and data networks; telecommunications; applications development; applications support and maintenance; desktop; project management; contract and vendor management; helpdesk and call centre; IS training and disaster recovery. The other is Business Process Outsourcing (BPO). This is the provision of business processes that depend on these applications. Core BPO services currently available in the market place are usually considered to include: finance and accounting; procurement; human resources and real estate.
The key differences between the two are that: first, in BPO the client will often have to play a more involved role; second, IT outsourcings tend to be very technology sensitive; and third, it is often the case that in IT outsourcing the client will have made some attempt to define the internal service levels prior to the outsourcing while for BPO, in view of the nature of the services, this is less likely to have happened.
Examples of failures in 2001
When outsourcing relationships fail they can receive considerable publicity and can have a significant cost implication on the client business. Examples of high profile reported failures in 2001 include the following. In February CGNU terminated its seven-year (GBP) 124 m outsourcing contract after only 2 years as part of a drive to consolidate its IT system. In April 2002, Hackney Council announced it was seeking £30m in compensation from ITNet following the collapse of its 10 year outsourcing deal signed in 1997. The Benefit Fraud inspectorate released a damning report in July relating to the proposed outsourcing of IT and business processes following the collapse of Lambeth council's outsourcing contract with Capita Business Services for its benefits and revenue service.
Importance of service description and service levels
Surveys have revealed that one of common reasons for outsourcing failures is a failure to concentrate and detail the actual services which a service provider is to provide. Often, parties can be distracted or seek comfort from the drafting of basic contractual provisions in the front end of the outsourcing agreement which set out the framework of the relationship. However, such provisions are to a certain extent worthless without an adequate service description.
The service description, with accompanying service levels, is often found in a schedule called the service level agreement or SLA. Adequate detail is important for the following reasons:
1. So that both parties know what they have to do. Operations staff will have to work out what each party has to do at some point and the sooner work on this is commenced the better.
2. A service provider cannot price the service if it does not know what it has to provide. The inclusion of additional services after signing the contract can result in a price creep, whereby the client business finds it has to pay additional sums for services which it thought would be included.
3. An SLA coupled with financial penalties and incentives provides an incentive to the service provider to perform well.
By whom should it be undertaken and when
The development of the SLA is something which should be developed by technical experts together with lawyers. The technical staff obviously have the relevant expertise in the field; the role of legal adviser is equally as important to ensure that the SLA is correctly worded and can be understood by future users of the agreement and any court, arbitrator or expert and to ensure that there is consistency throughout the outsourcing agreement.
The development of the SLA is a difficult task. Some client businesses may not have the necessary expertise to develop one in-house and will be more reliant on input from the service provider. This is particularly true as mentioned earlier in relation to BPO - while a client business may have its own internal service levels for IT delivery it is less likely to have this for, say, finance and accounting.
For a client business wishing to outsource a function as a starting point it is important that it undertakes its own analysis and due diligence as to what it wishes to outsource - a review of the internal service; assets; employees; third party contracts etc.. If a tender process is being followed, then such analysis can be used as a basis for developing the Invitation to Tender (ITT) or Request for Proposal (RFP). Such analysis is also necessary so that a client business can properly negotiate with the service provider. If a client business does not consider it has the necessary expertise it can instruct consultants to assist it in the development and negotiation of SLAs.
In an ideal world the parties will agree SLAs prior to signing the contract. From the perspective of the client business this is when its negotiating position is at its strongest. Defining service levels after signing leaves the client business exposed. In law an agreement is already in place and there is little reason for the service provider to agree to a high level of service; such negotiations may also result in price increases. Developing and negotiating a detailed SLA is a costly exercise and requires the service provider itself to undertake due diligence of the customer's function. One option that is seen in practice is that a supplier charges for the development of an SLA on a time and materials basis once it has been selected as a preferred supplier in a tender process. There is still an incentive on the service provider to secure the contract, but it is not completely financially exposed; for the client business it can decide not to proceed if it is not happy with the proposed service and price.
In practice there may be commercial pressure to sign an agreement before all the service levels can be agreed. In the past I have seen mechanisms whereby the parties undertake as much as possible prior to signing. To the extent that it is not possible for the service provider to undertake all the necessary due diligence prior to signing and for the SLA to be properly detailed the finalisation of outstanding aspects could be structured to take place during a fixed period thereafter. Such a mechanism is best undertaken against a measurable, for example the determination of existing service levels. If the parties cannot agree, then provisions could be included allowing the parties to terminate the agreement without liability. Alternatively areas of dispute could be referred to expert determination for determination.
Drafting service description
As a general rule, a client business will want to ensure that the services are not drafted in a way such that services which it is expecting are missed out. There is no magical solution to this other than careful drafting and review of the service description. One obvious drafting technique is to include a broad description of what is to be provided and then list specific services in more detail following the words "including without limitation".
Another technique is to concentrate on output rather than individual tasks. This avoids the risk of inadvertently missing out a specific task and allows flexibility if the tasks to perform an output vary during the term of the agreement.
It is also important to remember that there is the need for flexibility in the services over time. Technology will obviously change, particularly in relation to IT outsourcing. Lack of flexibility is also one of the common reasons for outsourcing failures. Overly detailed service description can hinder such flexibility. Flexibility also requires good change control procedures or change management procedures.
Before dealing with the drafting of service levels, it is worthwhile mentioning that it is useful to include common contractual provisions relating to service provision in addition to service levels. This is to cover, in particular, those aspects of the service which are not covered by service levels. Provision can be included to cover:
1. The provision of the service with reasonable skill and care; or in accordance with best industry practice or good industry practice.
2. Reference can be made to particular specified standards, e.g. Computer Services and Software Association (CSSA) code of conduct for outsourcing; International Standards (ISOs) where appropriate and British Standards (BSOs).
3. The provision of service in accordance with all applicable laws, regulations and guidelines of regulatory and competent authorities.
As an aside, it should also be remembered that it will be necessary to define the client business' obligations, particularly in BPO. Such obligations are sometimes called "operating services".
Service levels
Service levels are provisions which require the service provider to perform specified outputs to a particular level bringing certainty as to what is to be delivered. The drafting of service levels requires adherence to a number of practical rules:
1. As with service description one should concentrate on specific outputs rather than tasks.
2. The service levels must be measurable - adequate measurement mechanisms need to be in place.
3. Importance of focussing on key measures in any SLA - over complex SLAs can create monitoring problems.
When determining service levels one needs to define a baseline for the provision of the service. If this is a true outsourcing of an existing business function then often the baseline that is chosen is the existing baseline. However, the client business will normally be looking for service improvements and this needs to be built in to the agreement - for example, annual improvements in the service. It is also true to say that the greatest improvements come from changes to the whole process including changes to the client business processes.
In IT Outsourcing Agreements one commonly sees the following service levels, although these are just examples:
Availability - the proportion of time that the service is available - actual over scheduled time expressed as a percentage.
Reliability - the number of interruptions to a service, expressed as a number of outages and length of outages.
Performance - response times for certain actions.
There is no right or wrong answer to the time period over which service levels are to be measured - in practice one sees service levels measured over a monthly period; quarterly period; rolling period and annual period.
The point of measurement of service level is an important factor. A service provider will only wish to be responsible for those areas within its control.
It is common to draft service levels setting out a required service level target with lower levels of service whereby specific consequences occur, such as a fee deduction; it is also important to specify a level where the service is so low that the customer has the right to terminate.
Service levels and incentives to perform
Service credits or service level credits are terms used for financial penalties to service providers for poor performance. They are generally considered important for the following reasons:
1. As an incentive to the service provider to provide the services to a good standard.
2. Outsourcing relationships are normally fairly long-term arrangements - terminating the agreement is not an easy or attractive option for the client business.
3. Claims for damages unattractive where the parties have a continuing relationship.
4. Service level credits avoid the need to quantify loss which can often be difficult.
5. Service level credits may be particularly important if loss of profits as a liability of the service provider is excluded as this may be the only mechanism for obtaining financial redress in part for this area of loss.
A service level credit can be drafted as a reduction in the service charge or as a payment from the service provider to the customer.
Service level credits are normally drafted so that the amount increases the worse the performance of the service. One can attribute different amounts depending on how important the service level is. The actual amounts can be expressed as specific amounts; percentages of the service charge or a form of points system adopted where different service levels and failures have different weightings. When drafting service level credits as specific amounts, the recipient of the service will want to ensure that the amounts increase over time if the service charges increase.
As well as providing a "stick" to the service provider, mechanisms can be included to reward service providers for good service in the form of service level debits or bonuses paid to the service provider for good performance. They can have some advantage - if a service level, say availability, is set at a percentage below 100% then strictly there is no incentive for the service provider to achieve 100% availability. Client businesses are, however, generally reluctant to pay additional amounts for a service which they believe they should be getting in the first place. If service level debits arise it is more common to see them as part of a set-off mechanism diminishing the level of service level credits. To achieve this one can set up a mechanism for a service level credit/debit bank.
What should be the level of service level credits?
The level of service level credits needs to be considered in relation to a number of factors. First, as an incentive to the service provider to perform well, it needs to be at a sufficient level that it is a factor taken into account by a service provider, but not so high as to be crippling. To assist in determining this as rule of thumb a service provider's profit is generally between 5% and 20% of total price. Second, one needs to consider the consequences of service failure to the client business - what damage will the client business suffer. In practice one sees service level credits which are large compensatory amounts and also smaller amounts.
Law of liquidated damages and penalties
In order to decide how to draft service level credit mechanisms one needs to be conscious of the law relating to penalties. This is the principle that where parties to a contract agree that in the event of a breach, the contract breaker shall pay to the other a specified sum of money, the sum fixed may be classified by the courts either as a penalty (which is irrecoverable) or as liquidated damages (which are recoverable). A claim for a liquidated sum is enforceable if it does not exceed a genuine attempt to estimate in advance the loss, which the claimant would be likely to suffer from the breach of the obligation in question.
Related to this principle are a number of aspects which should be borne in mind:
1. "Genuine pre-estimate" is to be taken into account at the time the contract was made not as at the time of breach - Dunlop Pneumatic Tyre Co. Ltd -v- New Garage and Motor Co.Ltd [1915] A.C. 79;
2. The law of penalties only applies if it relates to sums payable for a breach of the contract - it does not apply where payable upon occurrence of an event other than a breach of a contractual obligation - Campbell Discount Co. Ltd -v- Bridge [1961] 1 Q.B 445 and Export Credits Guarantee Department-v- Universal Oil Products Co. [1983] 1 WLR 399.
3. The courts are reluctant to strike down a clause as a penalty clause as it is a blatant interference with freedom of contract and it has no place where there is no oppression - Robophone Facilities Ltd -v- Blank [1966]1 WLR 1428; Privy Council in Philips Hong Kong Ltd -v- Att- Gen of Hong Kong (1993) 61 Build L.R. 49.
4. If a sum is regarded as a penalty, the promisee should nevertheless receive by way of damages the sum which would compensate for actual loss - (this will be subject to limitations of liability elsewhere in the contract) - Jobson -v- Johnson [1989] 1 WLR 1026, Scandinavian Trading Tanker Co A.B. -v- Flota Pretolera Ecuatoriana (the Scaptrade) [1983] 2 AC 694.
5. Where the actual damages are greater than the liquidated sum the claimant can elect for the larger amount - Wall -v- Rederiaktiebolaget Luggude [1915] KB 3 66. However, liquidated damages can act as limitations of liability and exclude additional claims - Cellulose Acetate Silk Co Ltd -v- Widnes Foundry (1925) Ltd [1933] AC 20.
Drafting service level credits
In the market place there are 2 main ways of drafting service level credits (and such mechanisms can appear in the same agreement) and a third less common method:
1. One way is to specify that a failure to meet a service level is a breach of the agreement for which liquidated damages are payable, which are compensatory amounts. Such amounts will have to be a genuine estimate but this issue in practice is unlikely to arise as the service provider is not likely to agree to an unreasonable amount. The service provider may wish to make it clear that such amounts are instead of a claim for damages and are to be included in the overall cap on liability. The client business may wish to keep open its option to sue for actual damages in circumstances where its actual damages are higher as opposed to obtaining relief in the form of service level credits.
2. The other way is to draft the contract so that if the service provider fails to perform to a service level, a service level credit is payable at a low level which does not attempt to represent an estimate of loss. In such circumstances, the client business would wish to clarify in the agreement that the payment of service level credits is without prejudice to any claim for damages. Provisions may be included that the service level credits are or are not to be included in the overall cap on liability. This arrangement arguably is at odds with the law relating to liquidated damages as it appears to allow for a sum payable for a breach together with a right to claim damages. The alternative interpretation is that the service level credits are not attempting to be compensatory payments in lieu of damages but are a payment for a level of service and where there is no oppression, there is no public policy reason why the courts should interfere with such a commercial arrangement.
3. A way of circumventing the law on penalties is by specifying a low service level as the target level with a service charge which does not sufficiently reimburse the service provider. Bonus payments are then paid for the attainment of the higher service levels. As the amounts are bonuses (not deductions for payment of breach) the law of penalties does not apply. Such a mechanism has a disadvantage that there is no additional damages claim for poor performance as there has been no breach.
Conclusion
In summary for outsourcing arrangements to be successful, it is important for the parties to concentrate on defining the services and service levels.
Of course this is not the only requirement for a successful arrangement. It is worthwhile mentioning briefly a few other issues. For a successful outsourcing relationship the parties need mechanisms for service improvement on service level breaches. A key area of failure is also lack of flexibility - a relationship which is to last for 5 to 10 years must have the built-in flexibility to accommodate the inevitable changes to the business, especially in view of technology changes. This issue has been raised very recently by the analyst firm Gartner Group. At a contractual level, this requires the agreement to have good change control procedures and requirements and incentives for the service provider to periodically review the services and technology and propose changes. Benchmarking may play a role in ensuring the services are updated. To incentivise the service provider one is also seeing in the market place short term agreements for the long term - giving the client business the leverage to argue that it may go to another provider - e.g. in US - Cigna Healthcare of Atlanta and Entex Information Services.
For further information, please contact Yuban Moodley at yuban.moodley@cms-cmck.com or on +44 (0)20 7367 3453.
